Chapter 5 Time Value of Money Real Estate Example: You buy a property for $100,000.

What do you have to sell the property for in 5 years to make a profit. Say $125,000 so 125,000 $100,000 = $25,000 profit What is wrong with this analysis? Compare with Timeshare example to show the same issue. I. Present Value a. Financial rule that future money is worth less than present money i. Loss of liquidity ii. Opportunity cost of money iii. Risk b. Proper financial analysis requires all monies associated with a project to be stated in terms of the present or of the future. c. Cannot compare present and future money directly. Must put all money on the same footing. i. Present Value All monies are discounted to there value in the present ii. Future Value All monies are compounded to there value in the future. iii. Figure 5.2 Illustrates this concept 1. Invest $10,000 today for a steam of payments in the future. 2. Is this a good investment a. $10,000 returns $17,000 b. Have to compound the $10,000or discount the $17,000 returns to make a proper comparison.

II.

The simplest problem is the future value of a present amount. a. FV = PV * (1+i)n i. FV = future Value ii. PV = Present Value iii. i = rate at which you are willing to trade present money for future money. Often approximated by the interest rate. iv. n = Number of time periods usually year b. What is the Future Value of $800 invested for 5 years at 6%. i. FV = $800* (1.06)5 = $1,070.58 text rounds figure ii. Using Future Value Interest Factor - Table A1 c. Buy property for $100,000. What return did you make if you sell it for $125,000 d. Is this an adequate return on your investment

III.

What is the Present Value of a Future Amount a. PV = FV/(1+i)n or PV = FV * 1/(1+i)n b. What is the PV of $1,070.58 received five years in the future if the discount rate is 6% i. $1,070.58/1.33823 = $800 ii. Using Present Value Interest Factor Table A2 1. $1,070.58 * .74726 = $800 c. What is the PV of $125,000 received 5 years in the future if want 8% return on your investment i. $100,000 * .74726 = $93,407.50

IV.

Annuities a. An annuity is a steam of payments mostly equal but not necessarily i. Annuity Due Payment at beginning of time period ii. Ordinary Annuity Payment at the end of the time period

b. Calculations Use spreadsheet or table to compound or discount each year c. Perpetuity Annuity with no end i. Example Scholarship ii. You want to donate money to support an annual scholarship of $5,000. How much would you have to donate to MU to support the scholarship? iii. If return on investment will average 8% need $5,000/.08 = $62,500 iv. How much of a scholarship could be awarded each year for a $50,000 donation if investments return 8% $50,000 * .08 = $4,000 v. Recognize that a timeshare is perpetuity. 1. The company rents the condo for you using the interest on the capital you gave them. 2. This arrangement has no end V. Compounding a. Interest may be compounded annually but paid semi annually or quarterly or continuously b. Divide interest rate and multiply the time periods i. 6% paid semi annually for 5 years = 3% for 10 periods ii. $800 for 5 years at 6% paid semi annually 1. FV = $800 * (1.03)^10 = $1,075.13 c. For continuous FV = PV * ein i. E is natural log = 2.7183 ii. $800 * 2,7183(.06*5) = $1,079.89 VI. Nominal and Effective Interest Rate a. Compounding more than annually raises the effective interest rate above the nominal interest rate. b. EAR = (1 + i/m)m 1 m = compounding periods

c. A CD paying 8% compounded quarterly the effective rate is 8.16% d. Effective rate on a multi year investment i. $1,000 CD pays 4% for 5 years ii. FV = $1,000 * (1.04)5 = $1,216 iii. Annual percentage Yield = (($1,216 - $1,000)/$1,000) / 5 = 4.32% VII. Other Applications a. Annual payments to accumulate some desired sum i. How much would you have to deposit each year to have $20,000 at the end of 5 years expect to ear 6% on investment. ii. $20,000 / Sum of FV Interest Factor 1. Calculate the FV Interest Factor for each year an sum together 2. (1.04)1 + (1.04)2 + (1.04)3 + (1.04)4 + (1.04)5 = 5.633 iii. $20,000 / 5.633 = $3,550 b. Loan Amortization i. What schedule of payments is needed to pay off a loan ii. Tables A-4 PVIFA = 3.7 iii. $6,000/3.17 = $1892.74
Year 1 2 3 4 Sum Present Value Interest Factor 0.91 0.83 0.75 0.68 3.17

c. Growth Rates i. Periodic 1. FV = PV(1+i)n so (FV/PV)1/n = 1+ i so i = (FV/PV)1/n -1 ii. Continuous

1. FV = PVein

so

ln(FV/PV) = in

i = ln(FV/PV)/n

iii. Page 131 ln(1,520/1,250) = .19557/4 = 4.9% iv. FV = PMT * FVIFA calculate FVIFA and use Table A-4